I Bonds, Treasury Direct, and You
“I am willing to trade the pains (forget about the pleasures) of substantial short-term variance in exchange for maximization of long-term performance.”—Warren Buffet, American business magnate, investor, and philanthropist
What are I Bonds?
With inflation reaching 40-year highs, you have probably seen the recent news headlines about I Bonds paying 9.62%. The surge in inflation has made Federal Series I Savings Bonds (I Bonds) significantly more attractive for investors. I bonds are offered via the U.S. Treasury Department and are backed by the full faith and credit of the U.S. government.
What makes I bonds unique is their interest structure, which consists of a combined “fixed rate” and “inflation rate” that together make a “composite rate” – the actual rate of interest that an I bond will earn over a six-month period. For I bonds bought from May 2022 through October 2022, the composite rate is 9.62% which combines a 0.00% fixed rate with the 9.62% annualized rate of inflation as measured by the Consumer Price Index (CPI-U). The inflation rate can, and usually does, change every six months.
Buying I Bonds
In a calendar year, you can purchase up to $10,000 in electronic I bonds through the Federal Government’s TreasuryDirect website (www.TreasuryDirect.gov). You can purchase up to $5,000 in paper I bonds using your federal income tax refund. The limits apply separately, meaning you could acquire up to $15,000 of I bonds in a calendar year. You can also gift I bonds to adults or children but only if the recipients have a TreasuryDirect account. A child under 18 can have a TreasuryDirect account only if a parent or other adult custodian creates a minor linked account.
High net-worth investors should consider whether I bonds will actually make an impact on their overall portfolio, given the $10,000 limit. And administratively, it is another account to keep track of for estate planning.
Redeeming I Bonds
I bonds are generally seen as a long-term investment. I bonds are completely illiquid for the first year but can be cashed after 12 months. If you redeem the I bond before it is five years old, you will lose the last three months of interest. I bonds earn interest for 30 years if you don’t cash the bonds before they mature.
The interest earned on I bonds is subject to federal income tax, but not to state or local income tax. You can either report the interest every year on your individual tax return or you can defer reporting the interest until the sooner of: 1) you cash the bond, 2) you give up ownership or the bond is reissued, or 3) the bond stops earning interest at final maturity. When electronic I bonds reach final maturity, they are automatically cashed, and the interest earned is reported to the IRS. The interest is reported on IRS Form 1099-INT.
There is an education tax exclusion that permits qualified taxpayers to exclude the interest income if they pay for qualified higher education expenses at an eligible institution. However, you must meet certain criteria and are subject to income limits. To apply for the exclusion, you must attach IRS Form 8815 to your individual tax return.
Alternatives to I Bonds
Since I bonds can only be held in a TreasuryDirect (taxable) account, this adds a layer of administrative burden and tax complexity to the investor and potential heirs. There are other investments to consider which can be bought and sold in taxable brokerage and tax-deferred retirement accounts. Treasury Inflation-Protected Securities (TIPS) are inflation adjusted and are backed by the U.S. government. Certificates of Deposit (CDs) and U.S. Treasuries (T-Bills) provide principal protection and are paying competitive rates. As a practicable matter, equities are a better, more time-tested way of beating inflation, even if they can be more volatile in the short-term.